Working Paper: CEPR ID: DP228
Authors: Alberto Giovannini; Philippe Jorion
Abstract: Recent empirical work indicates that, in a variety of financial markets, both conditional expectations and conditional variances of asset returns are time-varying. The purpose of this paper is to determine whether these joint fluctuations of conditional first and second moments are consistent with the Sharpe-Lintner-Mossin capital-asset-pricing model (CAPM). We test the mean-variance model under several different assumptions about the time-variation of conditional second moments of returns, using weekly data from July 1974 to December 1986 on returns to a portfolio composed of dollar, Deutschmark, sterling, and Swiss franc assets, together with United States equities. The model is estimated constraining risk premia to depend on the time-varying conditional covariance matrix of the residuals of the expected returns equations. The results indicate that estimated conditional variances cannot explain the observed time-variation of risk premia. Furthermore, the constraints imposed by the static CAPM are always rejected.
Keywords: asset returns; equities; foreign exchange; risk premia; conditional variance
JEL Codes: 441; 521
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fluctuations in conditional variances (C22) | fluctuations in risk premia (E32) |
| lagged conditional variances (C22) | second moments of asset returns (G12) |
| nominal interest rates (E43) | second moments of asset returns (G12) |
| inclusion of US stock market (G15) | estimates of risk aversion parameter (D11) |